Rout Opens Opportunity for Investors Seeking Yield: Muni Credit

By Michelle Kaske -
Sep 6, 2013

The worst rout in the $3.7 trillion
municipal-bond market in more than two years is proving a gift
for wealthy investors buying through brokers and professional
asset managers who see a chance to make long-term money.

With state and local debt at its cheapest since April 2011,
such buyers are grabbing munis with yields at record highs,
according to data compiled by Bloomberg. For example, Ace Ltd. (ACE),
a Zurich-based property and casualty insurer, increased its muni
holdings by 15 percent in the first six months of this year.

Meanwhile, individuals who invest in munis mainly through
mutual funds, a strategy that requires less money, have
withdrawn the most since February 2011 on concern that the
Federal Reserve will scale back bond purchases, sending interest
rates higher and eroding the value of the funds.

“It’s a fantastic opportunity” as withdrawals force sales
by funds, said Peter Kuhn, a 52-year-old business owner from San
Jose, California. After investing more than $1 million in munis
through online broker-dealers, Kuhn said he has been buying more
in the past two weeks.

One investment -- $250,000 of general-obligation debt
issued by San Ysidro School District in San Diego County -- will
yield almost 7 percent, Kuhn said by telephone. The zero-coupon
bonds will pay debt and interest in future years, “and then you
get all the tax-free benefits,” he said.

Amid the withdrawals, smaller trades have increased. In
July and August, transactions of $100,000 or less, typically
involving individual investors, accounted for 85 percent of
municipal-debt trading, according to Municipal Securities
Rulemaking Board data. That’s the highest proportion of such
trades for those two months since at least 2006, the data show.

Other investors adding munis to their holdings include
property and casualty insurers such as Ace. The company had
$4.45 billion of the securities, based on fair-market value, as
of June 30, compared with $3.87 billion at the end of last year,
regulatory filings show. State and local debt accounted for 7.9
percent of its fixed-income investments, up from 6.8 percent on
Dec. 31.

CNA Buying

Stephen Wasdick, a spokesman for Ace, declined to comment
on why the insurer has boosted its muni investments.

CNA Financial Corp. (CNA), a Chicago-based insurance holding
company majority-owned by Loews Corp., invested $500 million in
the securities from April through June and may invest $500
million more before the end of this month, said James Anderson,
senior vice president for financial planning. The company tends
to buy local debt maturing in at least 20 years, he said.

“The combination of being able to lock in the higher
yields for such a long period of time, which matches our
liabilities, makes it very attractive,” Anderson said.

CNA’s second-quarter investments in munis brought its
holdings in the securities to $10.1 billion as of June 30,
regulatory filings show.

Muni Magnetism

Buyers of U.S. Treasuries and taxable corporate debt are
also investing in munis for their higher relative yields, Justin Hoogendoorn, a managing director at BMO Capital Markets in
Chicago, said in a Sept. 4 report. “Our trading desk has seen
increased purchase activity from crossover buyers, likely due to
these valuations,” he said.

The 4.76 percent yield on benchmark 30-year munis compares
with an almost 3.9 percent rate for Treasuries with similar
maturity, data compiled by Bloomberg show. The ratio of the
yields reached 122 percent yesterday, up from about 89 percent
on Jan. 3 as muni prices have fallen relative to U.S. government
debt. In the past week, that proportion has hovered near a level
last reached in December 2011, according to the data.

Negative headlines in recent months have fueled withdrawals
from muni-focused mutual funds, Hoogendoorn said. Detroit’s
record bankruptcy filing July 18 led to delays in bond offerings
by Michigan issuers amid concerns that defaults may increase in
cities burdened with unfunded liabilities and rising costs.

Fund Drops

The exchange-traded iShares National AMT-Free Municipal
Bond Fund fell 9.7 percent from April 30 through yesterday, when
it closed at $101.03 a share, its lowest closing price since
April 2011. By comparison, it dropped 12 percent from Sept. 9,
2008, less than a week before Lehman Brothers Holdings Inc.’s
bankruptcy filing, to Oct. 10 of that year, when the U.S.
announced plans to prop up Wall Street banks by buying shares.

As individual investors see the value of their muni mutual
funds decline, they sell to avoid deeper losses, said Ed Reinoso, chief executive officer of New York-based Castleton
Partners LLC, which manages $250 million of fixed-income
securities for people with a minimum of $2 million to invest.

“It’s become such a stampede that it’s created a real
opportunity,” Reinoso said. “We’ve been more active in the
past two months than we had been in the last 18 months.”

On Aug. 20, Reinoso bought Detroit School District notes
maturing in a year with a yield of almost 4.4 percent, about 14-fold more than top-rated munis of similar duration, data
compiled by Bloomberg show. The notes, rated SP-1, Standard &
Poor’s second-highest grade, were issued through the Michigan
Finance Authority, to be repaid with state-aid revenue.

It was the first debt sale by a Detroit issuer since the
city sought court protection.

Looking Deeper

Looking past the negative headlines and “digging out
situations that are extraordinary” gives investors higher
yields on securities with a reliable repayment stream, Reinoso
said. Such was the case with the school notes, he said.

“The principal and interest is already funded by the
state,” Reinoso said. “So you’re not buying a Detroit school
district, you’re buying the state of Michigan.”

Reinoso and Kuhn, the California investor, said they are
focused on fixed principal and interest payments that they can
collect tax-free rather than possible price changes of the debt.

A zero-coupon San Ysidro School District bond rated BBB-,
one grade above junk, and maturing August 2034 last traded Aug.
29 with an average yield of about 6.6 percent, data compiled by
Bloomberg show. The bonds are backed by Assured Guaranty Ltd. (AGO)

For investors in the highest federal income-tax bracket of
39.6 percent, that’s a taxable-equivalent yield of almost 11
percent.

Making Rent

“I view each muni bond that I own as an apartment,” said
Kuhn, a co-founder of IBP Insurance Services, an employee-benefits consulting firm. “It just pays me every day, every
month, every year. If I invest my money prudently and if I can
get 6 percent or 7 percent year in and year out, I’m good and I
don’t have to worry.”

In the broader market, states and municipalities plan to
offer $5.5 billion of long-term debt next week, led by a $758
million New York State Urban Development Corp. personal income-tax revenue deal, according to data compiled by Bloomberg.

At 3.14 percent, yields on benchmark 10-year munis are at
the highest level since April 2011. The interest rate compares
with about 3 percent for similar-maturity Treasuries.

The ratio of the yields, a measure of relative value, was
about 105 percent yesterday, compared with a five-year average
of 101 percent. The higher the figure, the cheaper munis are
compared with U.S. government debt.